The Nature of Econometricsand Economic DataC hapter 1 discusses the scope of econometrics and raises general issues that arise in the application of econometric methods. Section 1.3 examines the kinds of datasets that are used in business, economics, and other social sciences. Section 1.4 providesan intuitive discussion of the difficulties associated with the inference of causality in thesocial sciences.1.1 What Is Econometrics?Imagine that you are hired by your state government to evaluate the effectiveness of a pub-licly funded job training program. Suppose this program teaches workers various ways touse computers in the manufacturing process. The twenty-week program offers courses dur-ing nonworking hours. Any hourly manufacturing worker may participate, and enrollmentin all or part of the program is voluntary. You are to determine what, if any, effect the train-ing program has on each worker’s subsequent hourly wage. Now, suppose you work for an investment bank. You are to study the returns on dif-ferent investment strategies involving short-term U.S. treasury bills to decide whether theycomply with implied economic theories. The task of answering such questions may seem daunting at first. At this point, youmay only have a vague idea of the kind of data you would need to collect. By the end ofthis introductory econometrics course, you should know how to use econometric methodsto formally evaluate a job training program or to test a simple economic theory. Econometrics is based upon the development of statistical methods for estimatingeconomic relationships, testing economic theories, and evaluating and implementinggovernment and business policy. The most common application of econometrics is theforecasting of such important macroeconomic variables as interest rates, inflation rates,and gross domestic product. Whereas forecasts of economic indicators are highly visibleand often widely published, econometric methods can be used in economic areas that havenothing to do with macroeconomic forecasting. For example, we will study the effects ofpolitical campaign expenditures on voting outcomes. We will consider the effect of schoolspending on student performance in the field of education. In addition, we will learn howto use econometric methods for forecasting economic time series.
2 Chapter 1 The Nature of Econometrics and Economic Data Econometrics has evolved as a separate discipline from mathematical statisticsbecause the former focuses on the problems inherent in collecting and analyzingnonexperimental economic data. Nonexperimental data are not accumulated throughcontrolled experiments on individuals, firms, or segments of the economy. (Nonexperi-mental data are sometimes called observational data to emphasize the fact that theresearcher is a passive collector of the data.) Experimental data are often collected inlaboratory environments in the natural sciences, but they are much more difficult toobtain in the social sciences. Although some social experiments can be devised, it isoften impossible, prohibitively expensive, or morally repugnant to conduct the kinds ofcontrolled experiments that would be needed to address economic issues. We give somespecific examples of the differences between experimental and nonexperimental data inSection 1.4. Naturally, econometricians have borrowed from mathematical statisticians wheneverpossible. The method of multiple regression analysis is the mainstay in both fields, but itsfocus and interpretation can differ markedly. In addition, economists have devised newtechniques to deal with the complexities of economic data and to test the predictions ofeconomic theories.1.2 Steps in Empirical Economic AnalysisEconometric methods are relevant in virtually every branch of applied economics. Theycome into play either when we have an economic theory to test or when we have arelationship in mind that has some importance for business decisions or policy analysis.An empirical analysis uses data to test a theory or to estimate a relationship. How does one go about structuring an empirical economic analysis? It may seem obvi-ous, but it is worth emphasizing that the first step in any empirical analysis is the carefulformulation of the question of interest. The question might deal with testing a certain aspectof an economic theory, or it might pertain to testing the effects of a government policy. Inprinciple, econometric methods can be used to answer a wide range of questions. In some cases, especially those that involve the testing of economic theories, a for-mal economic model is constructed. An economic model consists of mathematical equa-tions that describe various relationships. Economists are well known for their building ofmodels to describe a vast array of behaviors. For example, in intermediate microeco-nomics, individual consumption decisions, subject to a budget constraint, are describedby mathematical models. The basic premise underlying these models is utility maxi-mization. The assumption that individuals make choices to maximize their well-being,subject to resource constraints, gives us a very powerful framework for creating tractableeconomic models and making clear predictions. In the context of consumption decisions,utility maximization leads to a set of demand equations. In a demand equation, the quan-tity demanded of each commodity depends on the price of the goods, the price ofsubstitute and complementary goods, the consumer’s income, and the individual’scharacteristics that affect taste. These equations can form the basis of an econometricanalysis of consumer demand.
Chapter 1 The Nature of Econometrics and Economic Data 3 Economists have used basic economic tools, such as the utility maximization frame-work, to explain behaviors that at first glance may appear to be noneconomic in nature.A classic example is Becker’s (1968) economic model of criminal behavior.E X A M P L E 1 . 1(Economic Model of Crime)In a seminal article, Nobel Prize winner Gary Becker postulated a utility maximizationframework to describe an individual’s participation in crime. Certain crimes have cleareconomic rewards, but most criminal behaviors have costs. The opportunity costs of crime pre-vent the criminal from participating in other activities such as legal employment. In addition,there are costs associated with the possibility of being caught and then, if convicted, the costsassociated with incarceration. From Becker’s perspective, the decision to undertake illegal activ-ity is one of resource allocation, with the benefits and costs of competing activities taken intoaccount. Under general assumptions, we can derive an equation describing the amount of time spentin criminal activity as a function of various factors. We might represent such a function as y ϭ f (x1,x2,x3,x4,x5,x6,x7), (1.1)where yϭ hours spent in criminal activities, x1 ϭ “wage” for an hour spent in criminal activity, x2 ϭ hourly wage in legal employment, x3 ϭ income other than from crime or employment, x4 ϭ probability of getting caught, x5 ϭ probability of being convicted if caught, x6 ϭ expected sentence if convicted, and x7 ϭ age.Other factors generally affect a person’s decision to participate in crime, but the list above isrepresentative of what might result from a formal economic analysis. As is common in eco-nomic theory, we have not been specific about the function f(и) in (1.1). This function dependson an underlying utility function, which is rarely known. Nevertheless, we can use economictheory—or introspection—to predict the effect that each variable would have on criminalactivity. This is the basis for an econometric analysis of individual criminal activity. Formal economic modeling is sometimes the starting point for empirical analysis, butit is more common to use economic theory less formally, or even to rely entirely on intu-ition. You may agree that the determinants of criminal behavior appearing in equation (1.1)are reasonable based on common sense; we might arrive at such an equation directly, with-out starting from utility maximization. This view has some merit, although there are casesin which formal derivations provide insights that intuition can overlook.
4 Chapter 1 The Nature of Econometrics and Economic Data Here is an example of an equation that was derived through somewhat informalreasoning.E X A M P L E 1 . 2(Job Training and Worker Productivity)Consider the problem posed at the beginning of Section 1.1. A labor economist would liketo examine the effects of job training on worker productivity. In this case, there is little needfor formal economic theory. Basic economic understanding is sufficient for realizing that fac-tors such as education, experience, and training affect worker productivity. Also, economistsare well aware that workers are paid commensurate with their productivity. This simple rea-soning leads to a model such as wage ϭ f (educ, exper, training), (1.2)where wage is hourly wage, educ is years of formal education, exper is years of workforceexperience, and training is weeks spent in job training. Again, other factors generally affectthe wage rate, but (1.2) captures the essence of the problem. After we specify an economic model, we need to turn it into what we call an econo-metric model. Because we will deal with econometric models throughout this text, it isimportant to know how an econometric model relates to an economic model. Take equa-tion (1.1) as an example. The form of the function f (и) must be specified before we canundertake an econometric analysis. A second issue concerning (1.1) is how to deal withvariables that cannot reasonably be observed. For example, consider the wage that a per-son can earn in criminal activity. In principle, such a quantity is well defined, but it wouldbe difficult if not impossible to observe this wage for a given individual. Even variablessuch as the probability of being arrested cannot realistically be obtained for a given indi-vidual, but at least we can observe relevant arrest statistics and derive a variable thatapproximates the probability of arrest. Many other factors affect criminal behavior that wecannot even list, let alone observe, but we must somehow account for them. The ambiguities inherent in the economic model of crime are resolved by specifyinga particular econometric model: crime ϭ ␤0 ϩ ␤1wagem ϩ ␤2othinc ϩ ␤3 freqarr ϩ ␤4 freqconv (1.3) ϩ ␤5avgsen ϩ ␤6age ϩ u,where crime is some measure of the frequency of criminal activity, wagem is the wage thatcan be earned in legal employment, othinc is the income from other sources (assets, inher-itance, and so on), freqarr is the frequency of arrests for prior infractions (to approximatethe probability of arrest), freqconv is the frequency of conviction, and avgsen is the aver-age sentence length after conviction. The choice of these variables is determined by theeconomic theory as well as data considerations. The term u contains unobserved factors,
Chapter 1 The Nature of Econometrics and Economic Data 5such as the wage for criminal activity, moral character, family background, and errors inmeasuring things like criminal activity and the probability of arrest. We could add familybackground variables to the model, such as number of siblings, parents’ education, and soon, but we can never eliminate u entirely. In fact, dealing with this error term or distur-bance term is perhaps the most important component of any econometric analysis. The constants ␤0, ␤1, …, ␤6 are the parameters of the econometric model, and theydescribe the directions and strengths of the relationship between crime and the factors usedto determine crime in the model. A complete econometric model for Example 1.2 might be wage ϭ ␤0 ϩ ␤1educ ϩ ␤2exper ϩ ␤3training ϩ u, (1.4)where the term u contains factors such as “innate ability,” quality of education, family back-ground, and the myriad other factors that can influence a person’s wage. If we are specif-ically concerned about the effects of job training, then ␤3 is the parameter of interest. For the most part, econometric analysis begins by specifying an econometric model,without consideration of the details of the model’s creation. We generally follow thisapproach, largely because careful derivation of something like the economic model ofcrime is time consuming and can take us into some specialized and often difficult areasof economic theory. Economic reasoning will play a role in our examples, and we willmerge any underlying economic theory into the econometric model specification. In theeconomic model of crime example, we would start with an econometric model such as(1.3) and use economic reasoning and common sense as guides for choosing the variables.Although this approach loses some of the richness of economic analysis, it is commonlyand effectively applied by careful researchers. Once an econometric model such as (1.3) or (1.4) has been specified, varioushypotheses of interest can be stated in terms of the unknown parameters. For example,in equation (1.3), we might hypothesize that wagem, the wage that can be earned in legalemployment, has no effect on criminal behavior. In the context of this particular econo-metric model, the hypothesis is equivalent to ␤1 ϭ 0. An empirical analysis, by definition, requires data. After data on the relevant variableshave been collected, econometric methods are used to estimate the parameters in theeconometric model and to formally test hypotheses of interest. In some cases, the econo-metric model is used to make predictions in either the testing of a theory or the study ofa policy’s impact. Because data collection is so important in empirical work, Secti